Don’t keep all your eggs in one basket.
This old saying is unbelievably applicable to us today. It’s really the heart and soul of successful investing, and it makes up the bulk of asset allocation strategies.
A Successful Asset allocation Strategy involves distributing your investment portfolio across various asset classes (stocks, bonds, cash, etc.). The percentage of each asset class is determined by the individual investor.
There is no simple formula that can find the right asset allocation for every individual. However, the consensus among financial professionals is that asset allocation is one of the most important decisions that investors make. Asset allocation is the primary determinant of most investment results.
Let me repeat that again. Asset allocation is a vital part of any investing strategy, and what works for me might not work for you. We might have drastically different needs, goals, and investment time frames.
Are Asset Allocation Strategies Important?
One of the first attempts to answer this question is the study performed by Brinson, Hood and Beebower in 1986.
They argue that 93.6 of investment return variations are explained by asset allocation policy. Since then, there have been debates over this finding.
In 2000, Ibbotson and Kaplan used five asset classes in their study Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? They concluded 1) that asset allocation explained 40% of the variation of returns across funds, and 2) that it explained virtually 100% of the level of fund returns.
All that said, just know that implementing an asset allocation strategy is a vital part of investing success.
The flip side of that coin is the importance with regards to loss.
By investing in asset categories that move up and down under different market conditions, an investor can protect against significant losses.
Historically, the returns of most major asset categories have not moved up and down at the same time. Stocks, bonds, cash, real estate, and commodities often behave very differently at any given time. One may go up, the other may plummet. Stocks and bonds in particular tend to behave in opposite manors.
By investing in more than one asset category, you’ll lessen the severity of loss, and investing will be a much smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteract your losses with better investment returns in another asset category.
Factors to Consider
Your asset allocation strategy is influenced by several important factors:
Someone who has inherited several million dollars might only need 2% return per year to support all necessary living expenses. If that were the case, would that person need to invest in volatile stocks to attempt to obtain a 10% annual return? Absolutely not.
What about if you’re young, like me, and don’t rely on any investment income? Because I have 40 years before traditional retirement age, and a lot of potential human capital at my disposal, I can take risks. If the stock market falls by 50% next week, who cares? It’s not a realized loss unless I sell out. All I have to do is keep buying on the drop and wait for it to rebound. It always has.
Can you withstand big fluctuations in the value of your investment portfolio? Can you sleep well at night after a 50% decline in the stock market like that of the 2008 financial crisis?
Your risk tolerance is your ability or willingness to accept investment losses in exchange for potentially greater long-term investment returns. The classic example of risk tolerance is related to how much of your investment portfolio you are willing to allocate to stocks. Stocks have historically had higher long-term returns than other asset classes, but more short-term volatility and some huge drops. In general, the higher your stock allocation, the higher your risk tolerance. Your risk tolerance will have a large influence on your final asset allocation strategy.
Investment Time Horizon:
How long can you remain invested before you need to use the money you’ve invested? If you have decades before you need the money, then you can afford more risk and volatility.
If you are going to need the money within a year, then you can afford little or no risk. This is why retirees often have safer portfolios, because many of them depend on the income each month and can’t afford to lose it all.
Individual goals are a huge part of an asset allocation strategy. If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or a child’s education, you will likely need to include at least some stock or stock mutual funds in your portfolio.
On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for the next summer vacation. If the market tanks, and you need the money, it won’t be there.
You can invest in almost anything these days, but It’s probably wise to stick to simple time tested assets like stocks and bonds. Most obscure asset classes carry much greater risk.
Easy to Follow and Invest:
- Stocks: Historically, stocks (equities) have had the greatest risk and the highest reward of the common asset classes. You can either buy stocks in individual companies or buy mutual funds (of ETFs) that hold stock in multiple companies.
- Bonds: Bonds have historically had lower risk and less reward than stocks. You can purchase either individual bonds or mutual funds that hold bonds from multiple organizations. I recommend the latter.
- Cash Equivalents: This includes cash as well as cash equivalents like certificates of deposit, savings accounts, and money market accounts. Cash is usually considered to be “safe” in the sense that you can’t lose money. However, cash equivalents often loses purchasing power due to inflation.
- Commodities: These include precious metals like gold and silver, agriculture, and energy. ETF’s are a great option to own commodities.
- Real Estate: These include Real Estate Investment Trusts (REITs) as well as local real estate.
Difficult to Predict
- Collectibles: This can include art, coins, stamps, etc.
- Derivatives: These include options and futures.
- Venture Capital and Hedge Funds: These are companies that specialize in startups, leveraged buyouts, arbitrages, etc. There is usually a large minimum investment required to participate in these.
How Much of Each?
A simple rule that many wise investors follow is to just hold your age in bonds. So at 23, I might hold 23% of all my investment assets in bonds. I personally think that’s too high in today’s environment. Bond returns have been bad, and interest rates will likely rise in the next 10 years, making long term bonds a terrible temporary choice. That leaves short term bonds which have very low interest payments. So in today’s world, I like stocks or real estate much more than bonds. In fact, I hold less than 5% of my portfolio in bonds.
After figuring the portion that you want to keep in bonds, most of the rest is usually allocated to stocks and real estate. You’ll have to decide where you want to put your money.
No matter what asset classes you own, you have to rebalance your assets.
Asset rebalancing involves modifying your investment portfolio to bring it back into alignment with your asset allocation strategy. You can rebalance your portfolio at periodic intervals (semi-annually, annually, etc.). Alternatively, you could rebalance based on a deviation threshold which occurs when your current asset allocation deviates a pre-determined percentage (1%, 2%, 5%, 10%, etc.) from your asset allocation strategy.
For example, suppose you start out with a simple asset allocation strategy of 60% stocks and 40% bonds. After a year, let’s assume stocks did well and bonds not so well. You’d then hold something like 70% stocks and only 30% bonds.
Rebalancing either means:
a) Selling part of your position in stocks, and purchasing more bonds to bring it back the the 60/40 allocation you prefer, or
b) Invest each month in the under-performing asset class, to keep the allocation close to the original strategy.
Since passive investing is a much better option for most people, option (a) is often the default, as they don’t want to mess with it, and they can just rebalance once every 12-13 months. It can be important to hold investments at least a year before selling, to obtain preferential tax rates, something I’ll address in another article.
Notice that in this example you have sold stocks that have increased in value and purchased bonds that have declined in value. This is a good thing because the net result is that you effectively followed an old investing maxim without even trying:
Buy low and sell high!
How to get Started
- Evaluate and Decide. You should create a strategy that makes sense to you and is compatible with your risk tolerance, goals, and needs.
- Define a rebalancing period. Your rebalance period or deviation threshold may be influenced by your tax costs. In other words, you may occur higher tax or trading costs if you rebalance more frequently. It helps if you can do your rebalancing in tax sheltered accounts (401K, IRA, etc.) and use no-load ETFs.
- Rebalance every period. This step is repeated many times.
- Adjust your asset allocation strategy as necessary. For instance, you may adjust your strategy as you age. Getting older often means owning less stock.
- There is no perfect asset allocation strategy. To define a perfect asset allocation strategy, you would have to predict the future perfectly. Unless you know some powerful magic or you have a crystal ball, don’t wait to find the perfect strategy.
- Stick to your asset allocation strategy when the market tanks. Many investors dumped their stocks during the Financial Crisis of 2007-2008 and lived to regret it. A major point of developing an asset allocation strategy is to remove the emotional component from your investment decisions.
- Use ETFs with low expense ratios for all your asset classes. This tip will allow you to keep as much of the investment gain as possible. Vanguard is my company of choice.
I hope you enjoyed this article on asset allocation strategies. Please sign up for email updates and leave a comment below!